A checklist for financial independence
The look at steps all investors can take to move along the pathway to independence.
I’ve written a fair amount about financial independence. I’ve talked about approaches investors can take at every lifestage. I’ve talked about the 5 steps to achieve the life you want through investing. And I've talked about how the pursuit of wealth may lead to unhappiness.
There are plenty of checklists enumerating the steps needed for financial independence. I am taking a little bit of a different approach today. Emergency accounts, setting a goal and coming up with an investment strategy are critical. However, the pathway to independence is paved by knowledge and this checklist is focused on creating the true foundation for achieving your goals.
1. The time value of money formula
Creating a financial plan and making the necessary course corrections as your situation changes is the key to financial independence. To do this effectively requires an understanding of how different decisions will impact your future. The time value of money formula is the principle that a dollar today is worth more than a dollar in the future.
This simplistic concept connects the value of something today with the value in the future. As savers and investors the connection between those two values is the amount we save and the return we earn. The contrasting force we battle is inflation which erodes the value of a dollar over time.
Understanding the relationship between how much you save, the return you earn and the time you have to compound your returns will determine the amount of money you will have in the future. A fundamental understanding of these relationships will enable you to make the trade-off between current spending and future spending.
Remember algebra? Algebra allows us to rearrange the variables in the time value of money formula to solve for the return needed to achieve a certain amount of money in the future. That number is the required rate of return to achieve your goal. The return needed is key to asset allocation decisions and tracking progress against your goal.
Find a financial calculator online and play around with the impact of adjusting the different inputs. Then set a goal and see what it takes to achieve it.
2. Understand that financial services industry is trying to sell you things you probably don’t need
We have grown accustomed to the fact that companies are trying to sell us goods and services and retain a natural scepticism that our interest and theirs may not be aligned.
However, my experience is that people ignore this paradigm when considering financial products. This is partially by design as the complexity of investing is continually stressed which leads to the inevitable conclusion that expertise – costly expertise – is required to achieve your goal. This is seldom the case.
The bottom line is that the financial services industry is trying to sell you on the notion that you should trade more and buy new products. Neither of these actions is likely in your best interest. Investors should be focused on outcomes and not on products.
Trading more increases your transaction costs, likely increases your taxes and leads to poor investor outcomes. We have reached the saturation point on funds and ETFs. The vast majority of new products are likely to have little use as you try and achieve your goals.
If you are pursuing an investment strategy based on ETFs the broad index tracking products have been around for years. They should make up the core of your portfolio. New ETFs are generally based on narratives that are designed to be enticing and often carry significantly higher fees than foundational products. They are mostly marketing inventions and designed to improve the issuing companies bottom line and not yours.
Brokers encourage frequent trading through a constant barrage of new ideas and market news which creates the impression that successful investing requires the nimbleness to respond to each new headline.
The key to achieving your goals is a thoughtful long-term plan that is consistently and arduously followed over decades. A study from the HAAS School of Business at the University of California divided brokerage customers into quintiles based on frequency of trading. Over a 5-year period the 20% that traded the most trailed the market return by 6.5% per year. Want to be a successful investor? It might be as simple as trading less.
3. Remember that expectations are priced into the market
Many investors are intoxicated by first order thinking. Their reasoning is that a company or industry or country with high projected growth must make a good investment. That couldn’t be further from the truth.
The market is forward looking. In practical terms that means that investor expectations about the future are reflected in prices. The performance of the market is therefore not how a company, industry or country performs. It is how that performance compares to investor expectations. Exceed investor expectations and good things happen. Fall short of investor expectations and be prepared to be disappointed.
While not known for investing commentary, Pamela Anderson once said “It is great to be blonde. With low expectations it’s very easy to surprise people.” While the truth in this sentiment is almost universally acknowledged, many investors take the opposite approach.
Yearning for the next big thing causes many investors to chase hype. They find safety in the herd which is a strange place to be when so many investors say they are trying to outperform the herd.
The truth is that expectations often get ahead of reality and become unmeetable when you inject a healthy dose of greed into the equation. Dollars follow hype which leads to new competitors, wasteful spending and ill-timed consolidation. None of that is conducive to strong investor returns.
Yet hype is conducive to creating new investment products. It is conducive to marketing those products. It is conducive to creating an environment that leads to poor investor choices like over-trading and chasing performance.
This point is driven home by Jeremy Siegel’s book The Future for Investors. His research uncovered the surprising best performing share in the US between 1925 and 2003. It changed my view of investing forever.
4. Anyone can be a successful investor
An important place to end this article is my unwavering believe that investing has the opportunity to transform lives. As an individual investor I hear all the time about how investing is too hard to do on our own. How it can’t be done without hiring professionals. How the deck is stacked against us. I don’t believe a word of that.
That is not to say that being a successful investor is easy. It involves time and effort to develop the foundational knowledge to do it successfully. It involves discipline and patience. It requires well defined goals and a plan which is consistently followed. All attributes in short supply. Yet despite the challenges it is something that everybody can do.
I found the challenge and potential rewards of investing to be empowering. It was all up to me. My gender didn’t matter and my background didn’t matter. The opinion of naysayers and sceptics didn’t matter. All that mattered was me and the decisions I made. That realisation is the first step to independence.
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